Eyes on the Investment Menu

As the 401(k) plan enters its fifth decade, the workplace retirement plan continues to evolve to meet the changing needs of employers and plan participants. This evolution includes advisers helping plan sponsor clients make changes to their plan menu to, in turn, help the participants succeed.

“The challenge in the design of the investment menu has always been the fact that when you look at an employee population, you have all different levels of sophistication,” says Mike Shamburger, head of core markets at T. Rowe Price in Baltimore. “You have some executives who are very knowledgeable about investments and some associates who have never owned a mutual fund—in or out of a plan.”

Plan sponsors and advisers have been working for decades to build an investment lineup that is simple enough for everyone to understand, but that also offers a level of sophistication for investors who can handle it, Shamburger says.

In response to that challenge, today’s plans provide fewer potential savings options and more asset-allocated offerings such as target-date funds (TDFs)—also automatically enrolling participants into them. Further, there has been growth in various strategies aimed at helping plan participants transition from saving for retirement to living off retirement income.

“I remember talking to plan sponsors years ago, when putting a small-cap fund into the lineup was a big, monumental, game-changing decision,” says Winfield Evens, vice president of investment solutions and strategy at Alight Solutions in Lincolnshire, Illinois. “That was a long time ago on a planet far, far away. The world has gotten more stable in terms of design and framework than it was in the past.”

“There’s been a big trend toward rationalization, consolidation, debranding and institutionalization of plan menus,” observes Holly Verdeyen, head of defined contribution (DC) at Russell Investments in Tacoma, Washington.

While the modern plan menu can vary significantly, depending on the goals of the plan sponsor and the demographics of participants, trends such as those cited above shape the way employers and advisers now think about plan menu design fundamentals. Sources discuss the biggest of the trends:

Methodical Fund Evaluation

The key to developing and maintaining the best plan menu for participants, advisers say, is to create a strong investment policy statement (IPS), laying out in detail the criteria the sponsor will use to choose new funds or eliminate existing ones.

The Employee Retirement Income Security Act (ERISA) does not require plans to have an IPS, yet having one is a best practice from a fiduciary perspective and gives the plan sponsor and adviser a framework they can refer to, says Mike Geraci, senior product manager, retirement consulting investment services for Commonwealth Financial Network in Waltham, Massachusetts.

“We suggest to any of our advisers or plan sponsor clients that if they don’t have an IPS in place to meet with the committee and establish one,” Geraci says.

Of course, once a plan sponsor creates an IPS, it is imperative that the committee follow it and document the process of doing so. Having good processes and documentation in place will guide plan sponsors to an outcome and actually make it easier to reach decisions, Shamburger notes.

The Evolving Target-Date Fund

Since the Pension Protection Act of 2006 (PPA), target-date funds have steadily grown as not only the default option for employees automatically enrolled into a 401(k), but also as the go-to for plan sponsors trying to choose a qualified default alternative investment (QDIA). Last year, 75.9% of employers used a TDF for that purpose, up from just 66% in 2017, according to research from the PLANSPONSOR DC Survey.

Still, while plan participants might be happy to “set it and forget it,” plan sponsors and their advisers are continuing to find ways to tweak and adjust target-date funds to better meet these employees’ needs.

“The TDF is the crown jewel of the defined contribution plan, and it’s where most participant assets are held,” Verdeyen says. “But there is a recognition that we can do even better, even if the TDF has served us well over the past 15 years.”

The next generation of TDFs may consider factors other than age such as an individual’s salary, deferral rate or other sources of savings, Verdeyen adds.

Display Options Clearly

Constructing a menu with the right investments and framing helps all participants understand their options and allows them to select a choice or path that most appeals to them.

Investment menu nomenclature

Investment options included

Source: Invesco, “Watch Your Language”

Demand for Asset Allocation Solutions

Participants show interest in having both target-date and target-risk funds available. Invesco found that almost 70% preferred professionally managed options to single asset class options.

Streamlining Choices

For many plan sponsors, reviewing participant data and learning more about investor behavior has led to a realization that the quality of funds in each plan is more important to outcomes than the quantity. This has resulted in steadily shrinking fund lineups.

“For a long time, we as an industry were in a place where retirement plans had many investment options, and the focus was on education and getting participants to invest properly,” says Paula Smith, senior vice president of product strategy and development at Voya Investment Management in New York City.

However, research showed that a larger number of investment options led to lower participation rates, and plan sponsors began looking for ways to pare back their plans.

In 2011, the average large employer offered more than 25 funds as investment options to participants; today, 10 years later, that number is less than 16, according to Fidelity Investments.

Plan advisers agree that, while it is important to make sure a plan offers funds in all major asset classes, having too many fund choices can lead to investor confusion or decision fatigue.

“The only rule of thumb is to provide enough diversification for people to build individualized portfolios for themselves. On the equity side, the conventional wisdom is to make sure you’re covering the Morningstar Style Box,” says Shamburger, referring to Morningstar’s nine-square grid that provides a graphical representation of a stock’s “investment style.”

Besides helping participants avoid decision fatigue, streamlining the menu has benefits for the plan sponsor, as well, says Chris Herman, head of investment strategies at Fidelity Investments in Boston.

“When a plan sponsor has 25 funds in its lineup, it has responsibility for oversight of all 25 of them,” he says. “If you reduce that to 15 funds, you have a lower burden of work and a lower risk. And when you reduce the funds in a category to one, you avoid a situation where someone might claim you had one good one and one bad one. After all, one fund is going to always outperform the other.”

White-Label Funds of Funds

One approach to streamlining a core menu is to roll up several managers’ offerings into a single, white-label fund within an asset class.

“So if a fund has five large-cap growth funds and three large-cap value funds, it might package them together and offer it as one U.S. equity option,” says James Martielli, CFA, CAIA, head of investment solutions in the institutional investor group at The Vanguard Group Inc. in Malvern, Pennsylvania. “It creates something that’s a little easier to understand.”

Using a bundled, white-label fund increases diversification without the participant getting paralyzed by choice, Martielli adds. It also eliminates the fund brand names, which could confuse some participants. There are benefits to plan fiduciaries as well, including the ability to switch out more fund managers on the back end, as necessary, without having to give notice and communicate the change to participants.

Building these funds in a way that improves participant portfolios takes a lot of work by plan sponsors and their adviser. Rather than simply looking at the brand name of a fund or the offerings from their recordkeeper, plan sponsors have to examine factors such as long-term tracking error, downside capture, excess returns and consistency of returns, Verdeyen says.

While fees still matter in this analysis, plan sponsors are more focused on building a fund composed of multiple managers, which will offer a less volatile experience for participants.

“You can make the experience more measured and consistent for participants by combining all of the styles underneath the fund,” Verdeyen says. “That’s the way plan sponsors have thought about still keeping as much or more diversification in the lineup, with fewer seats around the table in terms of the number of funds.”

Use the Right Words

Investment jargon can be confusing and stymies decisionmaking. Does the plan’s language resonate with participants, or have they stopped listening? To help increase participant engagement and understanding, use personal, positive and plausible words in plain English.

Source: Invesco, “Watch Your Language”

CITs Come Downstream

Replacing mutual funds with collective investment trusts (CITs) is a trend that, advisers say, has existed for years at large plan sponsors, but has started to move into the middle market, giving midsize sponsors an opportunity to reduce expenses while continuing to provide their participants with diversified offerings.

“Over the last five to seven years, we’ve really seen the institutionalization of CITs,” Geraci says. “The minimums are being waived, and we’re seeing [the investments] added to recordkeeping platforms, so there is broad availability. Some of them have tickers now, so you can pick them up as an investor and look at them on Morningstar or Google Finance.”

CITs are the second-most prevalent investment option, after mutual funds, in today’s 401(k) plan, with 78% of plan sponsors using them. That is an increase of about 25% from a decade ago, according to Callan. The shift reflects a decrease in prices, making CITs less expensive than mutual funds while offering the same strategy equivalent, Geraci says.

A Blend of Active and Passive

Plan advisers say the pendulum continues to swing back and forth between plan sponsors wanting more active or more passive investments.

“Cost pressure and perceived fiduciary benefits have put a wind behind the sails of passive management in recent years,” Shamburger says. “But plan sponsors also have to understand that it’s not simply about managing the expense side. They also have to pay attention to returns.”

Most sponsors have not entirely abandoned active management. Instead, they increasingly offer blended options to their participants, or focus on one approach or the other depending on the asset class. The case for active management in efficient markets such as large-cap domestic equities, for example, might not be as compelling as the case when it comes to bond funds or emerging market stocks, Smith says.

As to selecting active managers, plan sponsors increasingly look for proven track records and best-in-class performance, Shamburger says.

“There used to be all of these stats that passive investments were outperforming active, but what we [ultimately] saw was there was a huge universe of active management,” he adds. “If you just look at the top funds and the top managers, you would see outperformance. People are getting more selective about choosing the active managers they work with.”

Three Tiers

Some advisers take a tiered approach when considering the plan menu, guiding sponsors to think about their offerings in terms of three separate levels of participant experience. The first tier is the default option, typically a target-date fund, aimed at younger participants and hands-off investors who prefer not to take an active role in their investments.

The second tier provides the building blocks for more “do-it-myself” investors, providing a handful of funds across asset categories, which they can use to construct their own category. This tier may also include a brokerage window if plan participants tend to be more sophisticated investors. The third tier is aimed at in-plan retirees. It focuses on helping them convert their savings into income.

Managed Accounts

Whether or not they use the tiered framework, plan sponsors increasingly are working with their adviser to introduce managed account options that recognize the heterogeneity of plan participants. While a target-date fund may be the best solution for most participants, managed accounts aim to serve those who may have a more complicated financial picture. This could mean a participant who has significant savings outside of the plan or those making the financial transition into retirement.

“Managed account solutions are a way to address the limitation of the target-date fund,” Herman says. “Target-date funds are the same for any person who chooses a [particular] vintage. The managed accounts solution is a recognition that we could do better if we know more about the participant.”

Art by Gérard DuBois